Unit 8: Public Goods and Externalities

What is the difference between the car you own and the highway that your car drives on? What is the difference between growing potatoes and fishing in the open ocean? These questions are not meant to trick you. They are meant to show the student why the different characteristics of goods matter to the field of economics.

Differences Between Public and Private Goods

In order to better understand the role of government in the economy, it would be beneficial to explore the difference between public and private goods. Private goods are goods that are purchased and owned by individuals. A person can purchase a car. Any benefits derived from the car, for example driving to work, are experienced privately. The same unit of the good (in this case the car) cannot be consumed by more than one person at the same time – this is referred to as rivalness. A non-rival good can be enjoyed by several individuals at a time. For example, a movie theater, road, or public park can be enjoyed equally by all those who use up until the point at which crowding occurs. Once too many people are in the same theater, using the same road, or enjoying the park, their enjoyment decreases and the added use by an additional individual becomes costly. Most non-rival goods are subject to this type of congestion. In addition, the supplier of the good can prevent people who don’t pay from consuming the good (anyone who does not pay money to a car dealer does not get a car) -this is referred to as excludability. An excludable good is a good that only the consumer who purchased it may enjoy. Some goods such as a public park or a road may seem non-excludable. However, if we can limit access to the road by putting a gate or a toll booth on it, it becomes excludable. A public good on the other hand, is a good where the benefit can be enjoyed by other people. A supplier may not exclude someone from benefiting from a public good. For example, instead of driving a car to work a person could ride with others on a city bus. Public goods tend to be indivisible; they can not be divided into smaller pieces for individual purchase. There is no way to exclude someone from benefited from a good or service even if they didn’t pay for it. National defense is such an example. Public goods break the individual consumption-individual payment link. In the market you pay for what you consume. In the public sector this is not the case. Other examples of public goods would be disease prevention and scientific research. One bit of caution. A publicly provided good is not the same thing as a “public good.” Public organizations and governments delivery many goods which are private goods. Thus, it is not uncommon to see public organizations and private organizations producing similar goods such as education and medical care.

As we have learned in earlier chapters, a market economy outperforms other market systems in delivering goods and services. But on closer inspection, it does so primarily with private goods, where suppliers can exclude others from consuming a good and where the benefit is experienced privately. The problem lies in the nature of the good. If it is a non-excludable good rational consumers won’t be willing to pay for it if they can get a “free ride” from someone who does pay. The free rider problem exists when individuals have no incentive to pay for their own consumption and instead will take a “free ride” on anyone who does pay. Because of the free rider problem, self-interest alone does not lead to an efficient level of production for a public good. Because private goods are excludable suppliers will charge for them and so have an incentive to produce them.

In most cases, a market economy results in economic efficiency, because market prices and market forces guide the economy to efficient outcomes. Or stated differently, in most cases government intervention would lead to economic inefficiency, compared to the market. In most cases, there would be “Government Failure” if the government intervened and could not improve on market outcomes.

But what about the cases where the market outcome is inefficient? In some cases, perhaps a government outcome can increase efficiency, or decrease inefficiency. What then would be considered legitimate roles of government in the economy?

There are a variety of ways to provide for public goods. Governments frequently get involved but there are also nongovernmental solutions to the providing of public goods. Below is a list of some of the different ways available to provide public goods.

1) Voluntary contributions. Voluntary contributions are one way to provide some public goods. Many individuals contribute private donations to support public goods such as scientific research.

2) Self-interested individuals of firms. Some public goods are made available because individuals of firms are able to produce them and make money in an indirect way. The most familiar example would be broadcast television. An individual may watch non-cable stations for free, because the cost is picked up through advertising. Although there is no financial cost, viewers may have to endure programs they don’t like and many commercials.

3) Social encouragement. Individuals in a community can encourage or pressure other people to contribute money or time to provide a public good. An example of this type of provision for a public good would be volunteer fire departments in small towns. A second example would be when a social group volunteers to clean up a section of highway.

4) Government Support Through Taxes. This is the most common. Many public goods, such as national defense, roads, public health, are too expensive for small groups of people to pay for on their own, so they are provided for by the government through taxes.

How Much of a Public Good Should Be Provided?

Once a unit of government has decided to provide a public good, the next decision is how much of a public good should be provided. Governments must engage in cost-benefit analysis when they estimate the social cost and social benefits of providing a public good. When governments decide to fund a public good, they will engage in a cost-benefit study. For governments it is easy to estimate the cost of a public good, but much harder to estimate the benefit. Consumers of public goods do not always provide honest answers in how much they would be willing to pay for an extra unit of public benefit. A public good may also be what is called a common resource. A common resource is a public good where person A can not stop person B from consuming the public good, and the more consumption by person B means less of the public good available for person A. An example of this would be the fisheries located off the coasts of many countries. Anyone can go in a boat and catch fish. The more fish one person catches, means there are fewer fish for everyone else. Common resource goods create the problem of overuse. For the field of economics, overuse refers to how individuals ignore the fact that their use of a public good depletes the amount of the resource remaining for others. Fishing is an an example of overuse. If I have a fishing boat and catch many fish, I reduce the amount of fish available for others to catch. I have no personal incentive to worry about how this cost affects others. The same is true for traffic congestion. If I drive in my car alone and do not car pool, I make the trip to home (or work) during rush hour longer for everyone else who drives. To get consumers to think about the costs of their activities for the public, governments can try three approaches.

1) Tax or regulate the common resource. Examples of this would be to tax drivers on busy highways curing peak times, or to charge a fee to visit a national park. Using a tax to solve an externality problem can accomplish many things. It can force decision makers to consider the full cost of their decisions. It can also provide an incentive for firms to use a different technology. Lastly, it can be used to partially or fully compensate the damaged parties.

2) Create a system of tradable licenses for a common resource. The idea here is to get those who would gain the most from the use of a public good, to pay the most for a license. Fisheries around the world use this approach. You pay a high fee for the right to catch a particular type of fish. Such a system drives many fishermen out of business in the short run, but in the long run makes fishing a sustainable livelihood and promotes the growth of the public good (in this case a larger fish population).

3) Assign Property Rights of a Common Resource to a Group of Individuals. To correct the problem of overuse, a public good can be privately owned by a group of individuals who then have an incentive to protect the value of the good. An example would be giving public forest lands to private companies. There is an incentive for a private company to replace trees they cut down if they can exclude others from cutting the trees.

In previous units there was an explanation of how markets operate. But sometimes markets are not always efficient. When this happens, market failure is said to have occurred. Market failure occurs when the market produces too few or too many goods or services. Examples of market failure are lack of competition, externalities, public goods, and inequality. Correcting market failure usually requires the intervention of the government. Since the lack of competition and income inequality have been discussed in previous units, the focus here will be on externalities.

Externalities is a cost or benefit imposed on people other than the consumers and producers of a good or service. Another phrase used to describe externalities is “spillover effect”. People other than the consumers and producers who are affected by these spillover effects are called “third parties”. So, externalities can be seen as unintentional side effects of an activity affecting people other than those directly involved in the activity. Externalities can be either positive or negative. An example of a negative externality would be if a college student is trying to study for a test but the students in the room next door are playing loud music. The action of the the students next door to the student studying imposes an unwanted “external” cost on third parties who are trying to study or sleep. A negative externality exists when a cost spills over. An example of a positive externality would be a college education. Someone could use their college education to find a cure for cancer. A positive externality exists when a benefit spills over. Arthur Pigou, a British economist best known for his work in welfare economics, argued that the existence of externalities justified government intervention through legislation or regulation. Pigou supported taxes to discourage activities that created harmful effects and subsidies for those creating benefits to further encourage those activities. These are now known as Pigovian taxes and subsidies.

With respect to the impact of externalities on human society, ecological economist, Neva Goodwin, has observed, “power is largely what externalities are all about. What’s the point in having power, if you can’t use it to externalize your costs — to make them fall on someone else?”

When economists discuss the environment, they tend to focus on the cost and benefits of environmental decisions. This emphasis on costs and benefits does not mean that economists do not value a healthy environment. It simply means that they using economic tools to provide clarity.

One of the first starting points for economist in viewing the environment is the notion of externalities. As stated above, externalities refer to a cost or benefit that arises from an economic transaction and that falls on people who may or may not have participated in the transaction. For example, if a factory dumps toxic waste into a river killing most of the fish, it imposes an external cost on people who enjoy fishing. When the factory dumped the waste into the river, they did not take the views of those who enjoy fishing into account.

Externalities exist because of an absence of property rights. No one owns the air, the rivers, and the oceans. Which means, it is no one’s private business to ensure that these resources are used in an efficient manner. This creates inefficiencies. These inefficiencies exist because the market does not deal effectively with public goods. This is due to the “free rider” problem as mentioned above. Because the good is available to all whether they pay or not, everyone tries to get a free ride whether they paid for it or not.

Most of the environmental problems that we face today, such as global warming and air pollution, are the result of inefficiencies created by externalities. Governments attempt to address the market inefficiencies of public goods through the use of a variety of tools, from taxes to subsidies. For example, let’s assume the cost of producing a product is two dollars per unit, but an additional 20 cents per unit had been shifted to society as a negative externality in the form of dirty air. The government could place a 20 cent tax on each of the products produced to ensure that the firm pays the actual cost of production-which is now two dollars and twenty cents, including the cost of the negative externality (air pollution). Taxing to prevent an environmental negative externality may not always work. Individuals and companies can simply adjust their spending or may have a higher amount of income reserved for discretionary spending. In this situation, the tax acts more like a source of government revenue rather than a solution to the negative consumption externality. If the tax is cheaper than an alternative method of production, the pollution problem will not be solved.

The main way a government can protect its environment is through passing environmental standards. Environmental standards are rules that protect the environment by specifying actions by producers and consumers. For example, since the United States passed the Clean Air Act in 1970, emissions of pollutants into the air has fallen by more than a third. One way that is used to make the air we breathe cleaner is to use an emissions tax. An emissions tax is a tax based on the amount of pollution a firm produces. For example, a government might impose an emissions tax of $100 a ton. This will act as an incentive for the firm to decrease its harmful emissions.

Geography and Government Involvement

Sometimes geographic location can influence a government to adopt economic strategies that will assist citizens because of unique features of specific markets. The section below examines how the government gets involved to fix problems unique to urban and rural economies.

Urban Economics

Urban economics is the study of the location of households and firms. The study of urban economics introduces spatial considerations into our standard microeconomic models of human behavior and market analysis. One of the first areas of study in urban economics is understanding why cities developed where they did. Social location theory explores the relationship between geography and the development of cities. For a more detailed explanation of location theory click on the link below.

Location is one of the factors businesses use in determining where to build factories. Are there transportation hubs nearby ( such as waterways, railroads, and highways)? The spatial nearness of resources, such as raw materials and labor, are also important factors in the location of businesses.

A brief description of other relevant urban economic issues is provided below.

1. Land Use and Urban Sprawl. This is one of the most important economic issues discussed in American communities today. Urban sprawl refers to how development is spread out over large amounts of land through poor development. It threatens the environment as well as the quality of life for people in many ways. Sprawl puts long distances between homes, stores, and job centers; and makes people more and more dependent on driving in their daily lives. Economists studying urban sprawl look at its many costs to society- from air and water pollution to higher gasoline prices.

2. Housing and Urban Development. One of the main questions facing large cities is how to find land to build affordable housing for workers. One of the missions of our Department of Housing and Urban Development (HUD) is to assist urban communities in developing affordable housing for urban residents. For more information on the role of HUD, click on the link below.

3. Urban Transportation. How do we get workers from their homes to their places of employment? How do we pay for the construction of highways and subways? And what about the problems associated with urban transportation, such as traffic congestion and smog? Around the world, public transportation authorities are faced with mounting operations and maintenance costs, aging infrastructures, and reduced capital funding. Passengers resist higher fares or new taxes, while at the same time they demand better service and on-time performance. To read a proposal for reduced traffic congestion, click on the link below.

4. Urban Poverty. Over the last century there has been a mass exodus of people from the countryside to the cities. Most people move to cities in search of better paying jobs. But cities do not always produce enough jobs for its citizens, or if they do, many do not pay wages high enough to meet the high costs of living in a large city. This shortcoming leads to joblessness and poverty.

Rural Economics

Rural economics is the study of economic issues related to rural areas. As the United States has industrialized, life in rural America has changed. With these changes bring economic considerations. Issues such as farm subsidies and how to attract doctors to live in a small town, are concerns unique to rural communities. The information below will explore the relationship between economics and rural communities.

Rural businesses of all kinds – farms, small food processors, recreational and tourism enterprises, all face unique challenges because of their rural location. The United States Census Bureau statistics show people moving out of small, rural communities. This exodus, in addition to other factors, has created problems for rural economies. A brief description of some of these problems is described below.

1. Attracting Business Investment. There are a number of factors that make it difficult for businesses to locate in rural communities. Some of them include:

a) Lack of large labor pool. This may make it difficult to find necessary workers.

b) Additional transportation costs. The distance from transportation hubs and markets adds to the cost of the product.

c) Rural lifestyle. It may be difficult to attract and keep quality workers if they prefer the excitement and cultural benefits of an urban city.

2. Farm subsidies. Farm output fluctuates a great deal because of changes in the weather. Suppose there is a bad growing season, resulting in a bad harvest. What happens to the price of the crop, and the revenue of farmers?

Most governments intervene in agricultural markets. Governments intervene in two ways.

a) Set Production limits. Also known as quotas, production limits restrict the quantity produced and can result in a higher price than would normally occur in an unregulated market. Farmers benefit because they get higher prices. Consumers lose because they pay more.

b) Price Floors. As we have learned in an earlier unit, price floors are prices set above the equilibrium price resulting in a surplus. To make a price floor work the government must buy surpluses. This means the government ends up with a large inventory. The cost of buying and storing the inventory falls on taxpayers. Large, low-cost farms are the main beneficiary of farm subsidies. There are many people who believe farm subsidies should be eliminated because of this reason.

Health Care and Externalities

In health care, the critical externality in most systems is the care provided to others. One positive externality from health care is that you benefit from others being healthy because it reduces the likelihood of you catching their illness (assuming it’s contagious). You benefit from a positive externality of others receiving health care. A second negative externality is health care produces a great deal of chemical waste, and they require a great deal of emissions in the production process. A third interesting negative externality is the slowly growing resistance of antibiotics in bacteria. Positive externalities include how healthy workers are absent from work less and are more productive workers and how vaccinations have allowed many individuals to become immune to diseases and thus reduce the likelihood that everyone in the population will contract certain diseases.

Your health care costs are also affected by others choosing to purchase health care. The healthy pay more to the insurance company than they receive in treatment, while the opposite is true for the sick. Insurance fundamentally operates by taking the money from healthy people to pay for the procedures required by sick people.